Additionally, the US Fed has made significant steps as well. Not only is it starting another round of quantitative easing, it has gone even further by stating that: "If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability… A highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens." Hence, the FOMC is orchestrating an open-ended liquidity glut and promises to keep it going even once the economy is on a stronger footing again. I also agree with Lars Christensen (see here for his excellent Blog: The Market Monetarist) that this constitutes very positive news and while not exactly nominal GDP targeting, it is a significant step in the right direction.
The effects of this combination of the ECB removing significant tail-risk to the Eurozone economy and the US Federal Reserve providing an open-ended USD glut should not be underestimated. I am convinced that sentiment towards the Eurozone economy can improve with the current mild recession giving way to a low growth environment (below trend amid the fiscal tightening but positive growth nonetheless) over the next few months. Additionally, seasonal adjustments still play havoc with US economic data but now as we are entering autumn the drag from this factor (which depresses seasonally adjusted data during spring and summer) reverses and we should get better economic news over the next weeks. Hence, the environment should remain very positive for risky assets. Lower tail-risks, a stabilisation in the Eurozone economy and better data out of the US coupled with more liquidity should see an ongoing buy-on-dips environment. I am not particularly concerned with respect to the timing risk of Spain (and Italy) applying for help from the EFSF/ESM. This is a much different kind of risk than the fundamental risks of a debt-deflation spiral/Eurozone break up which we were facing before and should not cause more than some temporary volatility.
For markets I expect the following:
- Safety premia in safe-haven assets will be reduced further. Bunds/EONIA (and UST) curves can bear-steepen.
- The Euro can recover further as the short-squeeze carries on whereas the USD should get under broad-based pressure (hence EURUSD should move higher). Commodity, pick-up & emerging market currencies should start to be supported again by the USD glut.
- Credit spreads have much further to fall and credit spread curves should flatten. The trend towards record low nominal yields on carry products is not over.
- Hence, while during the first phase of financial easing being long duration and long credit was fine, now being short duration and long credit makes more sense.